We commonly hear that reducing DSO is the key measurement organizations should focus on when maximizing their collections efforts. While that can be true, there is another way to gauge how effective an organization is when collecting on receivables. The next time you calculate your organization’s DSO, try calculating collections effectiveness index, or CEI, as well.
Definitions of DSO and CEI
DSO is the financial ratio that identifies the average number of days it takes for a company to collect revenue from a customer after making a sale. CEI is the measurement of the collections staff’s effectiveness when collecting revenue from customers after the sale is made.
What’s the difference between the two?
Both measurements can be very useful tools and some organizations actually use both, but I’ve found that each one is best suited for a specific area of measurement.
DSO, which can be measured in months, quarters or years, is a good way to benchmark how quickly an organization collects receivables – especially if comparing to other organizations, as indicated by the formula below:
(Accounts Receivable / Annual Sales) x Days Per Year
DSO can also work hand-in-hand with the payment terms established by an organization when making the sale. If a supplier completes a sale with 30-day terms, measuring DSO will show how well customers are paying in relation to those terms. If DSO is 45 – 60 days, there is work to be done to lower DSO so it’s closer to the organization’s standard 30-day terms. In addition, the organization could determine how much those extra days of outstanding receivables are costing them by simply using the following formula:
( (Total Annual Receivables x Interest Rate) / 365) ) x DSO
By using this formula, an organization can determine whether it’s best to absorb the accumulating interest on the outstanding receivable or possibly receive early payment at a discounted rate that may be less than the accumulating interest.
CEI, on the other hand, is not necessarily used to benchmark against other organizations. Rather, CEI is used to determine the effectiveness of a collections staff in capturing outstanding payment from customers. The formula for CEI is as follows:
(Beginning AR + Sales – Ending Total AR) / (Beginning AR + Sales – Ending Current AR) x 100
As one might strive for a perfect score of 100 on a test, CEI measures how effective collections efforts are by providing a maximum score of 100 if those efforts are extremely buttoned up.
Which is better?
Determining which measurement is better actually depends on what an organization wants to measure. DSO is best when organizations want to understand how they may perform in relation to the rest of the industry as well as begin to measure the cost of those outstanding receivables. Furthermore, DSO is a good indication of how the organization is performing in relation to its standard payment terms. CEI, on the other hand, may be best for organizations hoping to align staff compensation to job performance or are interested in determining an internal measurement – regardless of the rest of the industry.
No matter which measurement your organization uses, it’s good to use at least one. Better yet, why not use both? The old adage that what gets measured gets improved certainly applies in both instances.